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Capital Spending Runs Out of Steam

Expiring tax break has dampened corporate demand for capital goods.

Business spending on capital goods, once an area of considerable relative strength, has weakened of late. When the spending pickup began earlier in this recovery, the utilization rates for existing facilities were so low that many expressed surprise. Only a little of the spending went for increased capacity, of course. Most of it was aimed at labor-saving equipment. Though this focus held back the pace of hiring, it did contribute to economic growth. While Tuesday’s report on October non-defense capital goods purchases showed a 0.8% rise, most of this year’s data suggest the demand has run its course and the capital spending sector, too, has fallen into the slow slog that has typified much of the rest of the economy for some time now.

From the beginning of this otherwise disappointing recovery, spending on new equipment showed remarkable strength. While overall real gross domestic product grew at 2% a year or less, the Commerce Department noted that from mid-2009 to year-end 2010, new orders for non-defense capital goods surged at a 17.1% annual rate. In 2011, even as the already sluggish economy slowed still further, the pace of new capital goods orders accelerated, growing almost 30%.

Three factors supported this growth. First, despite the generally slow pace of the recovery, corporate profits surged, initially by upwards of 50%, giving a wide variety of firms the wherewithal to finance such spending. Second, the flood of ambitious legislation developed during 2009—in particular Obamacare—left many business managers unsure of how much new employees would cost and eager to reorient their operations away from hiring and toward a greater reliance on equipment. Third, in September 2010, Washington passed temporary legislation that allowed smaller businesses to reduce their tax bill by expensing outlays for new equipment instead of writing the cost off gradually through depreciation. That tax break induced managers to hustle whatever spending they had contemplated to get it recorded while the government held to its generous policy.

But orders hit a wall this year. Non-defense capital goods orders, according to the Commerce Department, fell at an annual rate of almost 27% annual rate during the first half. Between June and August, such orders dropped at a 74% annual rate. September saw some recovery, but orders still have fallen at an annual rate of nearly 4% over the year so far, a radical shift from the previous strength.

In part, the slowdown should come as no surprise. Washington has long indicated that the tax benefit that allowed firms to expense instead of depreciate spending on capital equipment would end in 2013. As the year progressed, business realized that any further orders would turn into spending only in the coming year, by which time they would no longer be eligible for the tax break. No doubt these gyrations will smooth out in the new year, as Washington’s on-again, off-again approach ends, but to some extent the effort to get as much done while the breaks were in place has stolen spending from the future. Any future gains, consequently, will remain slow for some time to come.

More fundamentally, the recent weakness could also signal that business has largely exhausted the opportunities in labor-saving equipment. If that is the case, spending in 2013 may slow more dramatically than it might otherwise in response to the expiration of the earlier tax breaks. But such a circumstance, though pointing to even less overall economic support from business spending, would not be entirely negative. If business has really gotten to a point where it can no longer look as exclusively as it has previously to labor-saving applications, then it will likely have to pick up the pace of hiring, not necessarily to levels seen in past recoveries, but still above the poor pace to which the economy has grown accustomed in this recovery. Perhaps the somewhat surprising gains in employment recorded during the last couple of months are an early sign of just such a shift.

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